Investor ponders short sale's long-term risks

Q: I owned a parcel of raw land as investment property in Arizona until last month, when I sold it via a short sale. My $230,000 1099 is en route. My battle with the IRS will start in 10 months ... fun! I've researched it and found that Arizona is a non-recourse state, but that doesn't apply for the investment property. Any advice? --D.S. in California

A: Hmmm. Raw land, huh? Well, recourse vs. non-recourse (the issue of whether your lender can/will sue you for the deficiency) is a different but slightly overlapping issue from the tax issue (whether the state or Internet Revenue Service will impose tax on cancellation of debt income (CODI).

So, first, let's tackle the recourse issue. Now, you're correct that Arizona's non-recourse rule does not apply to your situation because the property was an investment (as opposed to your personal residence). That means that technically the lender could sue you for the deficiency -- the difference between what you owed on the property and what they recovered via the short sale (the $230,000 in debt that was canceled).

But few lenders of properties in states that are ordinarily non-recourse states are seeking deficiency judgments these days, as they're really not equipped to; most lenders who do pursue deficiency judgments are set up with regular attorneys in those states that allow it, as a rule.

Additionally, if you happen to be pretty broke, you might have been assessed by your lender to be "judgment proof," i.e., not worth spending the legal fees to go after on a "can't-squeeze-blood-from-a-turnip" theory.

There's no way to know 100 percent whether your mortgage lender will come after you, but the odds do point in your favor. One thing -- revisit your short-sale approval letter and every document you signed during escrow and at closing. It's possible that they may have included a provision whereunder the bank would waive your later liability for a deficiency judgment.

If you can find that -- it's worth a call to your broker or lawyer for help -- then you can rest assured there's no lawsuit coming. If you can't, you'll not know for sure until the statute of limitations has run: six years, if you signed the closing papers in Arizona; four years if not.

Now, onto the tax issue. For those who aren't aware, mortgage debt that is canceled through a short sale or foreclosure is normally subject to state and federal income taxes; it's known as cancellation of debt income (CODI) federally and in California, and discharge of indebtedness (DOI) in Arizona.

However, the federal and many state governments have put into place temporary laws eliminating this tax in the cases of many short sales and foreclosures; in fact, the federal version -- the Mortgage Debt Forgiveness Relief Act of 2007 -- does not expire until 2012.

The savvy researcher you are, you're probably aware that most of the temporary tax exemptions for short sales and foreclosures right now are applicable only to personal residences.

However, there is one other exemption that may alleviate or eliminate your tax burden: the insolvency exemption the IRS has for CODI. If you can make the case -- which many folks can right now -- that your net worth was zero or negative at the time of the foreclosure, you may be able to get out from under the federal income tax using the insolvency exemption.

Per the IRS website: "Is cancellation of debt income always taxable? Not always. There are some exceptions. The most common situations when cancellation of debt income is not taxable involve ... Insolvency: If you are insolvent when the debt is canceled, some or all of the canceled debt may not be taxable to you. You are insolvent when your total debts are more than the fair market value of your total assets."

Check out IRS Publication 4681 for more information about the insolvency and other exemptions you might be able to invoke. My advice is also to have your taxes prepared next year by someone who is very experienced with filing returns including short sales and foreclosures -- there are many certified public accountants who are also real estate attorneys and possess this expertise.

Choose a tax pro who will have your back and be able to document and argue your case persuasively in person in the event of an audit.

When it comes to your state income tax liability, this is definitely a question I would refer to the CPA or tax attorney you select. I don't have the facts to know whether your DOI income would require you to file a return in Arizona, or whether you can deal with this in the context of your California income tax return -- both states have similar temporary CODI/DOI income tax exemptions to the federal one (which won't apply to you because this was an investment property), but it's not clear to me whether either or both of them will also honor the insolvency exemption in your situation.

If you find a CPA/attorney who has worked with many California real estate investors, undoubtedly they will have run into this issue before, as investing in Arizona was a popular strategy a few years ago.